Internal Rate of Return Example

Say there are two proposed investments competing for funds: Company A and company B. The expected cash flows of both companies are shown below-

Year 0 -220 -220

Year 1 120 92

Year 2 100 59

Year 3 80 36

Year 4 55 19

Year 5 35 9

Year 6 20 4

Year 7 10 2

Total 200 0

There is an initial outlay of cash of Rs 220 in both the cases.

In the period of 7 years, company A brings a net gain of Rs 200 while company B brings in Rs 240 in the same period.

It is important to note that the cash flow streams of both companies differ significantly.

On one hand, company A has a large initial return which comes down each year, thus it is “front loaded”. On the other hand, company B initially has smaller returns which grow with every passing year, thus it is “back-loaded”.

Internal rate of return (IRR) myth

One of the biggest limitations of IRR is its reinvestment rate assumption.

This assumption states that the interim cash flows will be reinvested at the IRR (which is practically not always feasible).

This is the biggest misconception about IRR which is still followed by many B-schools even today.

To overcome this limitation, there is Modified internal rate of return (MIRR).

Modified internal rate of return (MIRR)

MIRR is a better and improved version of IRR. It does not assume that the cash flow of the project is reinvested at the IRR.

Rather, it includes a discrete reinvestment rate in the business model.

MIRR= nʆ(Sum of terminal cash flows / Initial investment) – 1

How is IRR used by the company?

Both NPV and IRR are used by the company to evaluate investment projects.

NPV simply tells you about the return one can expect from the project.

However, IRR is very helpful when you need to present to the non-finance people.

The reason being it is easy to understand and very intuitive.

Say if you explain to a non-finance folk that IRR from the project is 15% and the hurdle rate of the company is 10%, so one can easily make out that the company generates 5% extra return on the project.

While if you say that NPV from the project is Rs 2 lakh, it will not be clear to the audience.

Moreover, IRR is easily comparable while NPV is not.

Conclusion

The IRR is a simpler and a popular measure of investment performance.

Understanding IRR will help you in analyzing potential investments and will help you in long term.

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